The Inevitable Stock Market Reversal: The New Normal Is Just Another Bubble Awaiting A Pop

Is the New Normal of ever-higher stock valuations sustainable, or will low volatility lead to higher volatility, and intervention to instability?

Though we're constantly reassured by financial pundits and the Federal Reserve that the stock market is not a bubble and that valuations are fair, there is substantial evidence that suggests the contrary.

The market is dangerously stretched in terms of valuation and sentiment, and it does not accurately reflect fundamentals such as earnings and sales growth.

Why do we care? If we own no stocks in a retirement or other account, we don’t care; it’s mere background noise. But if we’re exposed to the gyrations of the stock market in any way, we should care, because those who sell near the top before the market drops preserve not just their initial capital, but their winnings from the 5+-year bull market. Those who fail to sell risk losing not just their gains, but quite possibly a material chunk of their initial capital.

Another reason to care is that those who bet the market will decline in a trend-reversal profit handsomely, just as those who buy at the bottom of a decline profit handsomely from the trend reversal from down to up.

Let’s start with the most fundamental truth: nobody knows the future. If any technique of prognostication worked every time, anyone with three 100% accurate forecasts in a row could turn $5,000 into $100,000 in three trades using options (or futures contracts). A decent rise or drop will triple an option bought before the move:

$5K -> $15K

$15K -> $45K

$45K -> $135,000

That few manage the apparently simple task of making three accurate predictions in a row (and being confident enough in the technique to leave all the chips on the table) is powerful evidence that no such technique works consistently enough to last even three trades.

That said, the benefits from being correct even once are powerful enough to make it worthwhile to pursue increasing the odds in our favor—even if the odds will never be 100% in our favor.

New Normal: Cycles and TA Banished, or Hubris?

There are three basic tools of prognostication: cycles, technical analysis and fundamental analysis. While each subject is broad, we can boil each down:

1. Cycles do not presume to predict the causes of trend reversals; they only reflect that such reversals often follow patterns over time. One example is the business cycle, which traces the expansion of credit and risky investments made with borrowed money and the subsequent contraction in credit as bad bets are written off. There are many cycles of varying duration: for example, lunar, solar and Kondratieff cycles.

2. Technical analysis seeks indicators that presage trend reversals. For example, declining volume and the narrowing of breadth (i.e. a handful of stocks is leading the index higher rather than broad-based participation in the rally) typically presage a breakdown of the rally.

3. Fundamental analysis holds that the stock market eventually re-aligns with the foundations of corporate valuations: earnings, sales and prospects for future profit expansion or contraction.

In the past six years of unprecedented central bank intervention—quantitative easing (buying of assets such as Treasury bonds and mortgages), zero interest rate policy (ZIRP) and “free money” liquidity (unlimited credit extended to financial institutions and financiers)—the belief that this New Normal is immune to downturns/trend reversal has taken hold, mostly for the reason that every downturn has been reversed by some additional central bank monetary intervention.

If the New Normal is truly permanent, then cycles and technical/fundamental analysis have been mooted: they no longer work because the central banks can push stocks higher essentially forever.

There is another school of thought which holds that central bank intervention so distorts markets that their efforts to eliminate downtrends introduce the seeds of instability which eventually disrupt the market.

Believers in the New Normal hold that the Fed and other central banks have an unlimited ability to print money and buy assets, such that they can buy up the majority of markets to keep valuations elevated.

We might also question the basic premise of the New Normal crowd which is that the recent past is an accurate guide to the future. To quote songwriter Jackson Browne: Don't think it won't happen just because it hasn't happened yet.

Though the New Normal faithful see cycles as banished by the godlike powers of central banks, I see a pattern in the New Normal:

Central bank intervention seems to have generated a new cycle: five years of a roaring bull market that reaches bubble heights and then crashes over the following two years.

Is there some reason to believe stocks can loft ever higher, other than central bank intervention?

The one fundamental metric that matters is profits. Let’s look at corporate profits and the S&P 500 (SPX):

It appears the stock market is responding to central bank intervention to the degree the interventions have enabled corporate profits to soar. How has intervention boosted profits? One easy way is that by lowering the cost of credit to near-zero, corporations have booked the savings in interest payments as profits.

The question of the New Normal boils down to: Can corporate profits continue soaring? Or perhaps more to the point: Can central bank intervention keep pushing profits higher? Since interest rates are already near 0%, the answer seems to be the fruit of QE and ZIRP have already been picked, and there is little more profit to be gained from these policies.

The Big Question: When?

Is the New Normal enforceable even as markets reach extremes, or is the faith in the central banks’ power to bend markets to their will just the latest manifestation of hubris?

No one knows at the moment, but as this article has shown, there are numerous persuasive reasons to be skeptical of the New Normal faith that markets can only loft higher in a permanent state of low volatility and rising profits.

In Part 2: The Signal That Will Tell Us A Stock Market Reversal Is Imminent, we present a number of markers that will indicate when the top is in and the uptrend has reversed. The cautious investor will do well to be attentive to these. Remember: locking in gains -- even if that means still leaving some upside on the table -- is vastly preferable than holding too long, and watching those gains evaporate.

Let’s start with the most fundamental truth: nobody knows the future. If any technique of prognostication worked every time, anyone with three 100% accurate forecasts in a row could turn $5,000 into $100,000 in three trades using options (or futures contracts). A decent rise or drop will triple an option bought before the move:

yeah... right...

It's not because you can see the goal and know the goal is there that you can score.

+100 This cannot be overemphasized - there is no price discovery. Any prices reported are based on a false sense of unfettered market participation and exchanges. True price distortions are arriving from POMO, ZIRP, and QE. There is no way true price discovery can occur under these circumstances. Watch, however, when the market does in fact crash - they will blame it on - wait for it - true price discovery. And then its rinse and repeat. And we get to do the whole thing over again. And we will be sitting here 6 or so years from now - saying exactly the same thing we are saying now.

Despite the horrific future the collapse will inevitably bring, I count down the days like a kid waiting for Christmas. We have to live in a world where truth wins, where honesty reigns and where REAL interests and relationships in the market are born through the common thread of supply and demand.

I am sick of stimulus, of intervention, of managed markets, of lying, of cheating, and of stealing. I view those who participate in the market today for the rigged gain akin to a group of gang rapers on a passed out chick at a frat party. You may get out before she wakes up, but you have culpability for your actions. There is a counter party in equity trading, and that little girl is somebody's retirement. I know it's easy to say "don't hate the player, hate the game" but if you participate you bear responsibility for the moral choice.

I wish I didn't have a conscious and I was a ruthless fuck but I guess I would rather be poor and mentally free than to participate by enabling a bullshit rigged casino.

Bravo, so well put. I feel the same.. I don't want to see suffering and I'm sure I will experience some degree of hardship from the coming reckoning.. but I am also compelled to see truth win. Because it will, sooner or later. A fool's paradise is just that - illusory. I don't want to wear a veil.

A powerful trend is a dangerous beast to go against as a trader.Most don't know that both The Fed and Treasury have their own trading desks and have unlimited liquidity at their disposal.The American Government and their Banksters are desperate and will do desperate things.That's what madmen do.If I were to pick only one person in the world who has their number it's James Rickards.If it's not to late,instead of giving half a billion dollars to the so-called "moderate" rebels in Syria could I please ask Obama to give the money to Detroit.

Is there some reason to believe stocks can loft ever higher, other than central bank intervention?

I'm affraid that central bank intervention alone is sufficient.

It's likely that the US equity market will never have a significant selloff again. It's arguably too politically risky to ever allow such a thing. Can you imagine a 1987 style sell-off with the POTUS saying "Well, it's only the stock market." as Reagan did? Not gonna happen.

A country can go down the shitter and still have the stock market go up every day (Zimbabwe, Venezuela etc.).

Agreed, no reversal on the horizon, a reversal would allow the currency debasers to buy up the entire global market, hyper inflation is here, the real question is how are they going to debase pink slime? add animals other than beef?

On quiet 4 pts days like this after the thieves have taken our money and left for the Hamptons, I wonder about the next meltdown.

US corps which own and control the US govt have shipped all the jobs and manufacturing to China, then used their private bank the "FED" to rob tax payers for generations and make them good on the bad banks bad debts MBS, etc. what's left? There is no strength or resilence left.

With a huge crash the "wealth effect" will evaporate, "noone" will be able to keep up with their mortage, debt payments, property taxes, high food and gas costs, they'll lose their homes, megabanks speculation profits will go, huge layoffs, all those who feed off the "new economy" selling consumer electronic toys on the internet will be out of business, smart phone will be $60-$100/mo debt phones, Google's ad rev will plumet. Eurozone PIIGS crisis will reappear will defaults.

No doubt a few plagues a MERS, SARS, BIRD, PIGS, or other 4 letter will co-incide with some earthquake, tsuamis, and nuclear meltdowns.

The US has a petroleum reserve for their war machines,is there a food reserve for the famine?

I hope you're right.. but Japan is also a highly homogenous, highly socialized and highly obedient culture. The US... not so much. Not to mention.. JP doesn't have tens of millions of FSA soldiers to contend with.

The CAC40 has broken to the downside a rising contracting triangle, this is a powerful pattern. I have sold all but one stock and have small short position.
I am at a lost why so much money is being forced into the US market, they are going to lose it.
The last time I sold all my stocks was 15/10/1987, and I still have the old paper contract notes from Young & Co.
My guess this time it's going to make '87 look like a pimple.
All my superannuation is in Cash, Gold stocks, Gold, and Productive farmland.

It would in free market, but this ain't a free market. I wouldn't be surprised if the FED gave free money directly to corporations(why stop there, pay them to take it!), in the next QE. That way, they can buy all their stock, and competition, at the same time.